NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
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1.
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The Company and Basis of Presentation
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AZZ Inc. (“AZZ”, the “Company”, "our" or “we”) was established in 1956 and incorporated under the laws of the state of Texas. The Company is a global provider of metal coating services, welding solutions, specialty electrical equipment and highly engineered services to the power generation, transmission, distribution, refining and industrial markets. The Company has two distinct operating segments: the Energy segment and Metal Coatings segment. AZZ Energy is dedicated to delivering safe and reliable transmission of power from generation sources to end customers, and automated weld overlay solutions for corrosion and erosion mitigation to critical infrastructure in the energy markets worldwide. AZZ Metal Coatings is a leading provider of metal finishing solutions for corrosion protection, including hot dip galvanizing to the North American steel fabrication industry.
Presentation
The accompanying condensed consolidated balance sheet as of
February 28, 2018
, which was derived from audited financial statements, and the unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information and in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete consolidated financial statements. These financial statements should be read in conjunction with the audited financial statements and related notes for the fiscal year ended
February 28, 2018
, included in the Company’s Annual Report on Form 10-K covering such period.
Our fiscal year ends on the last day of February and is identified as the fiscal year for the calendar year in which it ends. For example, the fiscal year ended February 28, 2019 is referred to as fiscal 2019.
In the opinion of management, the accompanying unaudited consolidated financial statements include all adjustments, consisting only of normal recurring adjustments, which are necessary to present fairly the financial position of the Company as of
August 31, 2018
, the results of its operations for the three and six months ended
August 31, 2018
and
2017
, and cash flows for the six months ended
August 31, 2018
and
2017
. These interim results are not necessarily indicative of results for a full year.
Accounting Standards Recently Adopted
On March 1, 2018, the Company adopted Accounting Standards Update ("ASU") No. 2014-09,
Revenue from Contracts with Customers (Topic 606)
and the related amendments ("ASC 606") using the modified retrospective method applied to those contracts which were not completed as of February 28, 2018. Results for operating periods beginning on or after March 1, 2018 are presented under ASC 606, while prior period amounts have not been adjusted and continue to be reported in accordance with the accounting standards in effect for those periods. However, for the three and six months ended August 31, 2018, the impact of applying ASC 606 as opposed to applying legacy accounting guidance did not result in a significant change to reported revenues or costs of revenues. Accordingly, no reconciliation has been provided to show the difference between applying ASC 606 and legacy guidance for the three and six months ended
August 31, 2018
. In addition, there was no cumulative effect adjustment to the beginning retained earnings on March 1, 2018 related to the adoption. See Note 2 for a description of the Company's accounting policy resulting from the adoption of ASC 606.
On March 1, 2018, the Company adopted ASU No. 2016-15,
Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments
, which clarifies the presentation and classification of certain cash receipts and cash payments in the statement of cash flows. The adoption did not have a material impact on the Company's consolidated statements of cash flows.
Recently Issued Accounting Pronouncements
In February 2016, the Financial Accounting Standards Board ("FASB") issued ASU 2016-02,
Leases (Topic 842)
. Under the new guidance, a lessee will be required to recognize assets and liabilities for all leases with lease terms of more than 12 months. Consistent with current GAAP, the recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee primarily will depend on its classification as a finance or operating lease. This ASU will be effective for the Company in the first quarter of its fiscal year 2020 and early adoption is permitted. The ASU requires adoption based upon a modified retrospective transition approach. The Company has not yet determined whether it will elect early adoption and is currently evaluating the impact of the adoption of this standard to its consolidated financial statements and related disclosures. In particular, the Company has made progress in assessing its portfolio of leases for accounting and disclosure purposes. To address the new standard's requirements, the Company is also in the process of assessing the design of the future lease accounting procedures and
related internal controls, selecting and implementing lease accounting software, and finalizing policies, including the election of any practical expedients permitted by the standard. While the Company has not yet completed its evaluation of the financial statement impact of the new lease accounting standard, the Company expects to recognize right of use assets and lease liabilities for its operating leases in its consolidated balance sheets upon adoption and thereafter.
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2.
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Summary of Significant Accounting Policies
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The Company’s significant accounting policies are detailed in Note 1 of its Annual Report on Form 10-K for the year ended February 28, 2018. The following section includes revised accounting policies related to the adoption of ASC 606.
Revenue recognition
The Company determines revenue recognition through the following steps:
1)
Identification of the contract with a customer,
2)
Identification of the performance obligations in the contract,
3)
Determination of the transaction price,
4)
Allocation of the transaction price to performance obligations in the contract, and
5)
Recognition of revenue when, or as, the Company satisfies a performance obligation
Revenue is recognized when control of the promised goods or services is transferred to the Company’s customers, in an amount that reflects the consideration that it expects to be entitled to in exchange for those goods or services.
The amount and timing of revenue recognition varies by segment based on the nature of the goods or services provided and the terms and conditions of the customer contract.
Energy Segment
AZZ's Energy segment is a provider of specialized products and services designed to support industrial, nuclear and electrical applications. Within this segment, the contract is governed by a customer purchase order and an executed product or services agreement. The contract generally specifies the delivery of what constitutes a single performance obligation consisting of either custom built products, custom services, or off-the-shelf products. When the Company does enter into an arrangement with multiple performance obligations, the transaction price is allocated to each performance obligation based on the relative standalone selling prices of the goods or services being provided to the customer and revenue is recognized upon the satisfaction of each performance obligation. The Company combines contracts for revenue recognition purposes that are executed with the same customer within a short timeframe from each other and that purport to be for a single commercial objective.
For custom built products, the Company recognizes revenues over time provided that the goods do not have an alternative use to the Company and the Company has an unconditional right to payment for work completed to date plus a reasonable margin. For custom services, which consist of specialized welding and other professional services, the Company recognizes revenues over time as the services are rendered due to the fact that the services enhance a customer owned asset. For off-the-shelf products, which consist of tubing and lighting products, the Company recognizes revenue at a point-in-time upon the transfer of the goods to the customer.
For services and custom built products, the Company recognizes revenues over time using a cost-to-cost input measure. This requires the Company to estimate the total contract revenues, costs and margin, which can involve significant management judgment. As a significant change in one or more of these estimates could affect the profitability of the Company’s contracts, management reviews and updates its contract related estimates regularly. The Company recognizes adjustments in estimated margin on contracts under a cumulative catch-up basis and subsequent revenues are recognized using the adjusted estimate. If the estimate of contract margin indicates an anticipated loss on the contract, the Company recognizes the total estimated loss in the period it is identified.
Due to the custom nature of the goods and services provided, contracts within the Energy segment are often modified to account for changes in contract specifications and requirements. A contract modification exists when the modification either creates new, or changes the existing, enforceable rights and obligations in the contract. For the Company, most contract modifications are related to goods or services that are not distinct from those in the original contract due to the significant interrelationship or interdependencies between the deliverables. Such modifications are accounted for as if they were part of the original contract. As a result, the transaction price and the measure of progress for the performance obligation to which it relates, is recognized as an adjustment to revenue on a cumulative catch-up basis.
In addition to fixed consideration, the Company’s contracts within its Energy segment can include variable consideration, including claims, incentive fees, liquidated damages or other penalties. The Company recognizes revenue for variable consideration
when it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur. The Company estimates the amount of revenue to be recognized on variable consideration using the expected value or the most likely amount method, whichever is expected to better predict the amount.
Metal Coatings Segment
AZZ’s Metal Coatings segment is a provider of hot dip galvanizing, powder coating and other metal coating applications to the steel fabrication industry. Within this segment, the contract is governed by a customer purchase order or work order. The contract generally specifies the delivery of what constitutes a single performance obligation consisting of metal coating services. The Company combines contracts for revenue recognition purposes that are executed with the same customer within a short timeframe from each other and that purport to be for a single commercial objective.
The Company recognizes revenue over time as the metal coating is applied to the customer provided material as the process enhances a customer controlled asset. Contract modifications are rare within this segment and most contracts are on a fixed price basis with no variable consideration.
Contract Assets and Liabilities
The timing of revenue recognition, billings and cash collections results in accounts receivable, contract assets (unbilled receivables), and contract liabilities (customer advances and deposits) on the consolidated balance sheet, primarily related to the Company’s Energy segment. Amounts are billed as work progresses in accordance with agreed upon contractual terms, either at periodic intervals (e.g., weekly or monthly) or upon achievement of contractual milestones. Billing can occur subsequent to revenue recognition, resulting in contract assets. In addition, the Company can receive advances or deposits from its customers, before revenue is recognized, resulting in contract liabilities. These assets and liabilities are reported on the consolidated balance sheet on a contract-by-contract basis at the end of each reporting period.
For the six months ended
August 31, 2018
, the Company recognized
$20.1 million
of revenues from amounts that were included in contract liabilities at February 28, 2018. The Company did not record any revenues for the three or six months ended
August 31, 2018
related to performance obligations satisfied in prior periods. The Company expects to recognize revenues of approximately
$18.2 million
,
$4.1 million
and
$1.5 million
in fiscal
2019
,
2020
and
2021
, respectively, related to the
$23.8 million
balance of contract liabilities as of
August 31, 2018
.
The increases or decreases in accounts receivable, contract assets and contract liabilities during the three and six months ended
August 31, 2018
were due primarily to normal timing differences between the Company’s performance and customer payments. The Lectrus acquisition described in Note 8 had no impact on contract assets or liabilities as of the date of acquisition.
Other
No general rights of return exist for customers and the Company establishes provisions for estimated warranties. The Company generally does not sell extended warranties. Revenue is recognized net of applicable sales and other taxes. The Company does not adjust the contract price for the effects of a significant financing component if the Company expects, at contract inception, that the period between when the Company transfers a good or service to a customer and when the customer pays for that good or service will be one year or less, which is generally the case. Sales commissions are deferred and recognized over the same period as the related revenues. Shipping and handling is treated as a fulfillment obligation instead of a separate performance obligation and such costs are expensed as incurred.
Disaggregated Revenue
Revenue by segment and geography is disclosed in Note 5. In addition, the following table presents disaggregated revenue by customer industry (in thousands):
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Three Months Ended August 31,
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Six Months Ended August 31,
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2018
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2017
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2018
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2017
|
Net sales:
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Industrial - oil and gas, construction, and general*
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$
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120,305
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$
|
115,834
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$
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271,613
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$
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228,919
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Transmission and distribution*
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60,152
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41,229
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|
|
126,106
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|
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84,339
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|
Power generation*
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42,330
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|
|
39,266
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87,304
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|
|
88,354
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Total net sales
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$
|
222,787
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|
|
$
|
196,329
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|
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$
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485,023
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$
|
401,612
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* The Company revised its internal methodology for allocating revenues by customer industry during the three months ended August 31, 2018. All prior periods have been recast to conform to this revised methodology.
Earnings per share is based on the weighted average number of shares outstanding during each period, adjusted for the dilutive effect of stock awards.
The following table sets forth the computation of basic and diluted earnings per share (in thousands, expect per share data):
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Three Months Ended August 31,
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Six Months Ended August 31,
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2018
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2017
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2018
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2017
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Numerator:
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Net income for basic and diluted earnings per common share
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$
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11,244
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$
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9,786
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$
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26,962
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$
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21,848
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Denominator:
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Denominator for basic earnings per common share–weighted average shares
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26,019
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25,970
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26,001
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|
25,991
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Effect of dilutive securities:
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Employee and director stock awards
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72
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|
|
66
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|
|
61
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|
|
74
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Denominator for diluted earnings per common share
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26,091
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26,036
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|
|
26,062
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|
|
26,065
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Earnings per share basic and diluted:
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Basic earnings per common share
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$
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0.43
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$
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0.38
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|
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$
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1.04
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$
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0.84
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Diluted earnings per common share
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$
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0.43
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$
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0.38
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$
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1.03
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|
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$
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0.84
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4.
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Share-based Compensation
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The Company has
one
share-based compensation plan, the 2014 Long Term Incentive Plan (the “Plan”). The purpose of the Plan is to promote the growth and prosperity of the Company by permitting the Company to grant to its employees, directors and advisors various types of restricted stock unit awards, performance share units, stock options, and stock appreciation rights to purchase common stock of the Company. The maximum number of shares that may be issued under the Plan is
1,500,000
shares. As of
August 31, 2018
, the Company had approximately
1,248,775
shares available for future issuance under the Plan.
Restricted Stock Unit Awards
Restricted stock unit awards are valued at the market price of our common stock on the grant date. Awards generally vest ratably over a period of
three
years but these awards may vest earlier in accordance with the Plan’s accelerated vesting provisions.
A summary of the Company’s non-vested restricted stock unit award activity for the
six month period ended
August 31, 2018
is as follows:
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Restricted
Stock Units
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Weighted
Average Grant
Date Fair Value
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Non-vested balance as of February 28, 2018
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109,777
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$
|
56.62
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Granted
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82,371
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|
42.00
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Vested
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(37,670
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)
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54.63
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Forfeited
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(7,290
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)
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55.27
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Non-vested balance as of August 31, 2018
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147,188
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$
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49.01
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Performance Share Unit Awards
Performance share unit awards are valued at the market price of our common stock on the grant date. These awards have a three year performance cycle and will vest and become payable, if at all, on the third anniversary of the award date. The awards are subject to the Company’s degree of achievement of a target annual average adjusted return on assets during these three-year periods. In addition, a multiplier may be applied to the total awards granted which is based on the Company’s total shareholder return during such
three
-year period in comparison to a defined specific industry peer group as set forth in the plan.
A summary of the Company’ non-vested performance share unit award activity for the
six month period ended
August 31, 2018
is as follows:
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Performance
Stock Units
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Weighted
Average Grant
Date Fair Value
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Non-vested balance as of February 28, 2018
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70,030
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$
|
54.59
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Granted
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46,183
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|
|
42.00
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Vested
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(3,378
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)
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46.65
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Forfeited
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(29,710
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)
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49.51
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Non-vested balance as of August 31, 2018
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83,125
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$
|
49.74
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Stock Appreciation Rights
Stock appreciation rights are granted with an exercise price equal to the market value of our common stock on the date of grant. These awards generally have a contractual term of
7
years and vest ratably over a period of
three
years although some may vest immediately on issuance. These awards are valued using the Black-Scholes option-pricing model.
A summary of the Company’s stock appreciation rights activity for the
six month period ended
August 31, 2018
is as follows:
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SARs
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Weighted Average
Exercise Price
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Outstanding as of February 28, 2018
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148,513
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$
|
43.29
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Granted
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—
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—
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Exercised
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(43,928
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)
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40.96
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Forfeited
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—
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—
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Outstanding as of August 31, 2018
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104,585
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$
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44.27
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Exercisable as of August 31, 2018
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104,585
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$
|
44.27
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The average remaining contractual term for those stock appreciation rights outstanding as of
August 31, 2018
is
2.33
years, with an aggregate intrinsic value of
$1.0 million
. The average remaining contractual terms for those stock appreciation rights that are exercisable as of
August 31, 2018
is
2.33
years, with an aggregate intrinsic value of
$1.0 million
.
Employee Stock Purchase Plan
The Company also has an employee stock purchase plan, which allows employees of the Company to purchase common stock of the Company through accumulated payroll deductions. Offerings under this plan have a duration of
24 months
(the "offering period"). On the first day of an offering period (the “enrollment date”) the participant is granted the option to purchase shares on each exercise date at the lower of
85%
of the market value of a share of our common stock on the enrollment date or the exercise date. The participant’s right to purchase common stock under the plan is restricted to no more than
$25,000
per calendar year and the participant may not purchase more than
5,000
shares during any offering period. Participants may terminate their interest in a given offering or a given exercise period by withdrawing all of their accumulated payroll deductions at any time prior to the end of the offering period. The fair value of the estimated number of shares to be issued under each offering is determined using the Black-Scholes option-pricing model. For the
six month period ended
August 31, 2018
, the Company issued
37,224
shares under the Employee Stock Purchase Plan.
Share-based Compensation Expense
Share-based compensation expense and related income tax benefits related to all the plans listed above were as follows (in thousands):
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Six Months Ended August 31,
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|
|
2018
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|
2017
|
Compensation expense
|
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$
|
3,659
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|
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$
|
3,400
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Income tax benefits
|
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$
|
823
|
|
|
$
|
1,088
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Unrecognized compensation cost related to restricted stock units, performance share unit awards, stock appreciation rights, and the employee stock purchase plan at
August 31, 2018
totals
$8.8 million
.
The Company’s policy is to issue shares required under these plans from the Company’s authorized but unissued shares.
Segment Information
Net sales and operating income by segment for each period were as follows (in thousands):
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Three Months Ended August 31,
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Six Months Ended August 31,
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2018
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2017
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2018
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|
2017
|
Net sales:
|
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|
|
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|
Energy
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$
|
106,515
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$
|
97,299
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$
|
253,501
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|
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$
|
210,504
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Metal Coatings
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116,272
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|
|
99,030
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|
|
231,522
|
|
|
191,108
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|
Total net sales
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$
|
222,787
|
|
|
$
|
196,329
|
|
|
$
|
485,023
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|
|
$
|
401,612
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|
|
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|
|
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|
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Operating income (loss):
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|
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Energy
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$
|
4,273
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|
|
$
|
2,363
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|
|
$
|
14,231
|
|
|
$
|
9,074
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|
Metal Coatings
|
|
22,076
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|
|
23,409
|
|
|
47,260
|
|
|
44,651
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Corporate
|
|
(9,244
|
)
|
|
(8,385
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)
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|
(20,690
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)
|
|
(16,315
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)
|
Total operating income
|
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$
|
17,105
|
|
|
$
|
17,387
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|
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$
|
40,801
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|
|
$
|
37,410
|
|
Asset balances by segment for each period were as follows (in thousands):
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|
|
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|
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|
|
|
August 31, 2018
|
|
February 28, 2018
|
Total assets:
|
|
|
|
|
Energy
|
|
$
|
574,230
|
|
|
$
|
554,866
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|
Metal Coatings
|
|
453,821
|
|
|
460,575
|
|
Corporate
|
|
9,973
|
|
|
12,768
|
|
Total
|
|
$
|
1,038,024
|
|
|
$
|
1,028,209
|
|
For the three and six months ended August 31, 2018, the Company recognized impairment charges of $0.8 million, which were classified within cost of sales in the consolidated statement of income and were related to property, plant and equipment in the Metal Coatings segment that was vacated or abandoned upon the consolidation of two galvanizing facilities in the Gulf Coast region of the United States. As part of the consolidation of facilities, the Company also recognized $0.5 million in employee severance and other disposal costs for the three and six months ended August 31, 2018, which were also classified within cost of sales in the consolidated statement of income.
Financial Information About Geographical Areas
The following table presents revenues by geographic region for each period (in thousands):
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|
|
|
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|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended August 31,
|
|
Six Months Ended August 31,
|
|
|
2018
|
|
2017
|
|
2018
|
|
2017
|
Net sales:
|
|
|
|
|
|
|
|
|
United States
|
|
$
|
188,278
|
|
|
$
|
162,490
|
|
|
$
|
401,834
|
|
|
$
|
329,219
|
|
International
|
|
34,509
|
|
|
33,839
|
|
|
83,189
|
|
|
72,393
|
|
Total
|
|
$
|
222,787
|
|
|
$
|
196,329
|
|
|
$
|
485,023
|
|
|
$
|
401,612
|
|
The following table presents fixed assets by geographic region for each period (in thousands):
|
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|
|
|
|
|
|
|
|
|
|
August 31, 2018
|
|
February 28, 2018
|
Property, plant and equipment, net:
|
|
|
|
|
|
|
United States
|
|
$
|
187,983
|
|
|
$
|
194,418
|
|
Canada
|
|
17,410
|
|
|
18,254
|
|
Other countries
|
|
4,011
|
|
|
4,183
|
|
Total
|
|
$
|
209,404
|
|
|
$
|
216,855
|
|
A reserve has been established to provide for the estimated future cost of warranties on a portion of the Company’s delivered products and is classified within other accrued liabilities on the consolidated balance sheets. Management periodically reviews the reserves and makes adjustments accordingly. Warranties cover such factors as non-conformance to specifications and defects in material and workmanship.
The following table shows the changes in the warranty reserves for the
six month period ended
August 31, 2018
(in thousands):
|
|
|
|
|
|
Warranty Reserve
|
Balance at February 28, 2018
|
$
|
2,013
|
|
Warranty costs incurred
|
(1,179
|
)
|
Additions charged to income
|
1,221
|
|
Balance at August 31, 2018
|
$
|
2,055
|
|
The Company's debt consisted of the following for each of the periods presented (in thousands):
|
|
|
|
|
|
|
|
|
|
August 31, 2018
|
|
February 28, 2018
|
2011 Senior Notes
|
$
|
125,000
|
|
|
$
|
125,000
|
|
2008 Senior Notes
|
—
|
|
|
14,286
|
|
2017 Revolving Credit Facility
|
171,000
|
|
|
162,000
|
|
Total debt
|
296,000
|
|
|
301,286
|
|
Unamortized debt issuance costs for Senior Notes
|
(321
|
)
|
|
(391
|
)
|
Total debt, net
|
295,679
|
|
|
300,895
|
|
Less amount due within one year
|
—
|
|
|
(14,286
|
)
|
Debt due after one year, net
|
$
|
295,679
|
|
|
$
|
286,609
|
|
On March 31, 2018, the Company made the final principal payment of $14.3 million to fully settle the 2008 Senior Notes on the scheduled maturity date.
On March 22, 2018, the Company purchased certain assets through a bankruptcy sales process from Lectrus Corporation, a privately-held corporation based in Chattanooga, Tennessee. Lectrus designs and manufactures custom metal enclosures and provides electrical and mechanical integration. The acquisition will complement AZZ's current metal enclosure and switchgear businesses.
This acquisition was not significant. Accordingly, disclosures of the purchase price allocation and unaudited pro forma results of operations have not been provided.